If I own a bunch of market funds which hold securities from secondary capital markets (stock and bond markets), am I partaking in unearned income/economic rent?

Let me clarify what I my question is NOT about:

  • It is NOT about IPOs. I know that when you trade your capital for ownership/debt that is providing productivity and value to the economy and cannot be considered unearned.

  • It is NOT about active management and trading where your actions provide efficiencies and price discoveries which provide valuable information and also is not considered unearned.

I am specifically talking about those who have their savings in a market fund (who bought their holdings off the secondary market) and provide basically nothing while they earn income/returns.

Is this thinking correct? Would this be considered unearned income?

Separate from but related to this question is: are capital gains taxes the same as corporate taxes? If they are different, and if the answer from above is "yes, savings held in secondary capital market funds are a form of unearned income", then wouldn't capital gains taxes be an efficient tax?

My thinking is that because taxing unearned income doesn't deter people (taxing a lottery winner won't stop them from claiming their prize), then taxing their capital gains seems to not have any effect on the saving rate of people.

EDIT: I am adding this edit to clarify (for my bounty) what type of answer specifically I am looking for.

I'll first say that the first part of this question is the part I want answered satisfactorily, but is more hypothetical or theoretical so it may be more difficult to answer. The second part can probably be answered with evidence or research as it is much more of a practical question.

Anyway, my first question is asking if owning market funds which hold securities from secondary capital markets is equivalent to an economic rent of sorts, i.e. is the gain in value of these assets "unearned" since no "work" was put in? When investing in an IPO or lending money, there is real productivity being done as your capital is being used to fund a project and there is an associated opportunity cost which means any value gain is "earned". Contrast this with owning these funds which rise in value at no action of the owner's. This is similar to earning an income from renting out land which many economists do view as economic rent.

To make it perfectly clear, this is part of the NOT about how a country might view income for tax purposes. I am talking about if the income gained from owning the market funds I have specified is equivalent to economic rent because no "work" is being done. I know that the holdings in market funds are not factors of production (unlike land) which is a requirement for income earned from ownership of those types of assets to be actually considered economic rent. However I am still asking if it is considered unearned income because if it is unearned, it is basically free money, no?

This is where the second part of question comes in. If it is considered unearned, would capital gains (and dividend) taxes be as efficient as a land tax? I ask this specifically because if income earned from these types of funds are "unearned", then it would mean any amount of taxation wouldn't be a deterrent, at least until the point where owners of these funds would rather do something more useful with their capital and actually invest.

I hope that clarifies my question.

  • $\begingroup$ Hi, welcome to economics.se. Questions of personal finance belong to personal finance and money stack $\endgroup$
    – 1muflon1
    Apr 12 at 17:59
  • $\begingroup$ @1muflon1 it didn't seem to really be about an individual's finances either, rather more about theoretical considerations about different kinds of taxes. $\endgroup$ Apr 12 at 19:57
  • $\begingroup$ @GS-ApologisetoMonica to me this looked like a question on how to classify it for filling personal taxes, maybe I misjudged it, if you think it does not belong on personal finance you can send it back to us $\endgroup$
    – 1muflon1
    Apr 12 at 20:00
  • $\begingroup$ @1muflon1 It is back with you :-) I agree the first part is a bit ambiguous but if it is a question about how to file taxes it would need to be more explicit about that. The second part at least seems definitely quite theoretical. $\endgroup$ Apr 12 at 20:09
  • $\begingroup$ Stack Exchange encourages one question per question. $\endgroup$
    – user253751
    Apr 13 at 13:23

This question is quite convoluted and uses accounting terminology rather than economic terminology (those two are diametrically different most of the time) but based on comments and further qualification I understood that in the first part you are asking whether return on equities are pure economic rent. I am sure you are talking about economic rent because you refer to 'efficient tax' and generally it is taxation of pure economic rents that does not cause welfare loss, not just anything where payment is conventionally called rent (e.g. rent is also term used for a payment for equipment etc).

Answer to Part 1 of Question

The answer is no for several reasons.

First, what is actually the definition of economic rent? An economic rent is (Alchian, 2017):

‘Economic rent’ is payment for use of any resource whose supply is fixed

A fixed supply means that no matter what the price is suppliers would supply the exactly same quantity of output. As you can plainly see this has nothing to do whether any work is done or not. I heard the no-work done analogy sometimes used in intro classes to simplify the concept for 101 econ students, but that is just simplification for people who have no economic training. A more correct way of putting it would be that economic rent is an income for activity where no economic sacrifice was made or where income does not depend on person's decision making (although these are still just simplified analogies).

This is also why taxing pure economic rent is 'efficient' (or better said does not cause inefficiency), since taxation creates inefficiency by changing quantity supplied and demand on market. But if supply is fixed and completely inelastic then a) all tax burden falls on supply side of the market b) there is no deadweight loss of taxation because taxing rent on such market will not change supply or demand (for more info on how deadweight loss of taxation depends on shape of supply and demand see Mankiw Principles of Economics Ch 8). Moreover, again remember this holds only for pure economic rents, not for payments that are traditionally or by accountants/tax offices called rents.

In economics term 'unearned income' is generally not used, that is a largely legal terminology*. The only prominent instance of use of 'unearned income' in economics that I know of was applied to pure economic rents by Henry George (see Gaffney 2017), some other economists might also use it this way but again it is not very commonly used terminology rather economic rent/pure rent/pure economic rent is used instead.

Generally speaking saving/supply of capital does not have fixed supply, so it cannot be taxed without efficiency loss (unless there are externalities involved but that is issue unrelated to rents or income in general). What even more, research actually shows that optimal capital taxes in long-run are actually 0 due to famous Chamley-Judd (Chamley, 1986; Judd, 1985) result that showed that in the long-run supply of capital is so elastic that all capital taxes are just shifted to labor income while creating distortions. The Chamley-Judd result was recently challenged, see discussion on that here, but there is very little doubt that taxing capital creates distortions even if optimal capital taxes might be non-zero in long run.

For example, seminal work of Summers (1981) showed that the elasticity of saving with respect to after tax rate of return is quite high although the result was also challenged by some recent work, I have no knowledge of any serious work trying to claim that elasticity of savings wrt after tax rate of return would be 0. Consequently, one can be quite confident that generally returns to savings are not economic rents, and generally it does not matter whether you save in form of some index fund or not.

Answer to Part 2

From accounting tax/tax code perspective they are not the same but as always accounting/legal terms have little to do with economics and from economic perspective that depends on situation.

Corporate taxes are taxes on profits/income corporations earn. In economics, capital taxes are any taxes that tax supply of capital (See Stiglitz Economics of Public Sector 3rd ed). A profit corporation earns is, among other things, also return for their supply of capital. Hence, to an extent that a business owners supply just capital to their business you could argue that they are same. However, if business owner also supply labor to their businesses (e.g. also work as managers/CEO's or we are talking about self employed plumbers) the tax on profit is both tax on capital and their labor. Consequently, from economic perspective they are the same in cases where owners of business supply only capital and nothing else.

PS: Note your analogy with lottery is extremely misleading.

Even with lottery if the tax is known in advance it would affect peoples' decision to enroll into the lottery (unless entry was completely free of charge). In case where the lottery would be free of charge the (e.g. everyone is automatically enrolled without any cost) the return from lottery would be pure economic rent but not because no work was done but because it does not affect the economic decisions in any way, because in that case no economic decisions were even made it was pure windfall profit that did not affected your economic activity, you would not supply more labor or capital to get that profit.

However, with saving the story is completely different. Saving is postponed consumption and consumption in the future always competes with consumption in the present. If you tax future consumption through capital taxes at higher rate than present consumption is taxed of course people will consume more in present than in future.

PPS: There is one important caveat: timing is important. Any economic decisions made in a past are already set. If you invest in a fund and sign a contract that you cannot withdraw your money before 5 years pass, then any new tax on that saving wont retroactively change your decision of course. But such 'surprise' taxes are one-trick pony. You can do that once and then people will adjust their expectations and in future behave with expectations that their returns might get surprise tax. So government can do this once or if people are not fully rational and forgetful maybe once per few decades.

* Although the term 'unearned income' is not widely used (you would not even find it in many standard economic textbook, or if only in side notes or boxes with news article excerpts), you will of course find a ton of research mentioning the term with reference to tax code. However, the terminology of tax code is based on law not on any economic rationale. E.g. all countries have different definitions of what 'unearned income' is and some countries do not even use that terminology.

  • $\begingroup$ Based on the definition of economic rent you provide, would land rent (rent a land owner would charge to a tenant) be considered economic rent? I ask this because the land owner did have an opportunity cost when they might have first bought the land. Wouldn't that disqualify it from being economic rent? $\endgroup$ Apr 18 at 18:55
  • $\begingroup$ @MrMineHeads the payment for land itself would be economic rent because supply of land is fixed - as I mentioned those other analogies are also imprecise - you should use the rigorous definition when deciding. However, IRL ‘rent’ landowner gets is not just compensation for supply of land but also for supply of land improvements and land maintenance which is not fixed. Eg if at exactly the same place land alone rents for 500 but land with improvements and maintenance for 1000 then even though both are called rents in the second case 500 is econ rent and rest would not be $\endgroup$
    – 1muflon1
    Apr 18 at 20:13

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.